As known in the art, structured financial products are financial instruments that are issued and sold by business entities (e.g., corporations) to investors for capital-raising activities. Typically, structured financial products are particularly designed and created by investment institutions for the business entities to meet the specific capital-raising needs of such entities. In turn, investors purchase structured financial products, focusing on payoff patterns (i.e., capital appreciation and/or current income) of the products, to address their specific investment objectives. As referred herein, an investor can be an individual, a group of individuals, an organization, or a business entity.
One of the many structured financial products in existence today is mandatorily convertible securities. As understood in the art, a conventional mandatorily convertible security (also referred to as Equity DECSSM, PRIDES, PEPS, MEDS, SAILS, PIES, or other names) is typically a preferred security issued by a business entity paying a cash distribution and a special feature, namely, an automatic or mandatory conversion into a certain predetermined number of units of an underlying security at a specified future time. The Equity DECS or DECS conversion feature typically works as follows: on the mandatory conversion date the DECS will convert into one share of common stock if the share price on such date is at or below the share price on the date the DECS was issued, however, if the share price on the mandatory conversion date is above the value of the share price on the date the DECS was issued, each DECS will convert into less than one share of common stock.
An investor sees the DECS as an attractive investment because he or she earns a higher income return on the DECS than he or she would receive as a common stockholder. However, in exchange for that enhanced income return, the investor gives up some participation in potential appreciation of the common stock (through the reduction of the number of shares into which the DECS is convertible). On the other hand, the business entity sees DECS as an attractive means of raising equity capital (from the credit rating agencies' perspective) while retaining a certain amount of potential appreciation in its common stock (through the delivery to the investor of fewer shares upon conversion if the stock has performed well). Moreover, the issuance of a DECS enables the business entity to raise capital by tapping a different pool of investors than those that would otherwise be purchasers of the business entity's common stock.
Because the conventional DECS is typically a preferred security, payments of cash distributions in respect of that security are deeply subordinated in the capital structure of the issuer in terms of its obligation to make such payments. As a result, investors typically demand a higher distribution (coupon) rate in return of the DECS (especially those from non-investment grade issuers) to compensate for greater risk stemming from the subordination of the DECS' distribution payment obligations to senior claims against the issuer. In certain circumstances, this subordination could discourage investors from purchasing DECS from a particular issuer altogether. As a result, the issuer may not attract the right pool of investors and/or command the requisite prices for their issued DECS. Also, for some issuers, another drawback is the accounting presentation of the DECS. Even though the instrument mandatorily converts into common stock at maturity, the payment obligations associated with the instrument would require classification of the DECS as a liability, rather than as equity. For issuers who desire to increase the amount of equity on their balance sheets for accounting purposes (as well as raise capital that is viewed as equity from the perspective of the credit rating agencies), this presents a problem.
Hence, there exists a need for a system and method for offering a structured financial product that provides all the benefits of a DECS, attracts investors to such product in spite of a less favorable credit rating of the product's issuer, enhances the issuer's pricing efficiency of the issued product, and, in some cases, enables the issuer to present the instrument as equity for accounting purposes.